Cost-Volume-Profit Relationship

Cost volume provit (CVP) analysis is a powerful tool that helps manager understand the
relationships among cost, volume, and profit. CVP analysis focuses on how profits are
affected by the following five factors:

1. Selling prices

2. Sales volume

3. Unit variable costs

4. Total fixed costs

5. Mix of products sold

Because CVP analysis helps manager understand how profits are affected by these key
factors, it is a vital tool in many business decisions. These decisions include what products
and services to offer, what prices to charge, what marketing strategy to use, and what cost
structure to implement.

The Basics of Cost-Volume-Provit (CVP) Analysis

Contibution Margin

Contribution margin is the amount remaining from sales revenue after variable expenses
have been deducted. Thus it is the amount available to cover fixed expenses and the to
provide profits for the period. Contribution margin is used first to cover the fixed expenses,
and then whatever remains goes toward profits. If the contribution margin is not sufficient to
cover the fixed expenses, then a loss occurs for the period.

Break-even point is the level of sales at which profit is zero. Once the break-even point has
been reached, net operating income will increase by the amount of the unit contribution
margin for each additional unit sold. To summarize, if sales are zero, the company’s loss
would equal its fixed expenses. Each unit that is sold to reduces the loss by the amount of
the unit contribution margin. Once the break-even point has been reached, each additional
unit sold increases the company’s profit by the amount of the unit contribution margin.

CVP Relationship in Equation Form

The contribution format income statement can be expressed in equation form as follows:

Profit = (Sales – Variable expenses) – Fixed expense

For brevity, we use the term profit to stand for net operating income in equations. When a
company has only a single product, as at Acoustic Concepts, we can further refine the
equation as follows:

Sales = Selling price per unit X Quantity sold = P X Q

Variable expenses = Variable expenses per unit X Quantity sold = V X Q

Profit = (P X Q – V X Q) – Fixed expenses

It is often useful to express the simple profit equation in terms of the unit contribution margin
(Unit CM) as follows:

Unit CM = Selling price per unit – Varible expenses per unit = P – V

Profit = (P X Q – V – Q) – Fixed expenses

Profit = (P – V) X Q – Fixed expenses

Profit = Unit CM X Q – Fixed expenses

CVP Relationship in Graphic Form

Preparing the CVP Graph

In a CVP graph (sometimes called a break-even chart), unit volume is represented on the
horizontal (X) axis and dollar on the vertical (Y) axis. Preparing a CVP graph involves three
step :

1. Draw a line parallel to the volume axis to represent total fixed expense.

2. Choose some volume of unit sales and plot the point representing total expense (fixed
and variable) at the sales volume you have selected. Afte the point has been plotted, draw a
line through it back to the point where the fixed expense line intersects the dollars axis.

3. Again choose some sales volume and plot the point representing total sales dollars at the
activity level you have selected.

Contribution Margin Ratio (CM Ratio)

The first step is we have added a column to Acoustic Concepts contribution format income
statement in which is sales revenues, variable expenses, and contribution margin are
expressed as a percentage of sales. The contribution margin as a percentage of sales is
referred to as the contribution margin ratio (CM ratio). This ratio is computed as follows:

Contribution margin
CM ratio =
Sales

The relation between profit and the CM ratio can also be expressed using the following
equation:

Profit = CM ratio X Sales – Fixed expenses

The CM ratio is particularly valuable in situations where the dollar sales of one product must
be traded off against the dollar sales of another product. In this situation, products that yield
the greatest amount of contribution margin per dollar of sales should be emphasized.
Target Profit and Break-Even Analysis

Target profit analysis and break-even analysis are used to answer questions such as how
much would we have to sell to make a profit of $10,000 per month or how much would we
have to sell to avoid incurring a loss?

Target Profit Analysis

In target profit analysis, we estimate what sales volume is needed to achieve a specific
target profit. We can compute the sales volume required to attain a specific target profit
using the following formula:

Target profit+ ¿ expenses

Unit sales to attain the target profit =
Unit CM

CVP Considerations in Choosing a Cost Structure

Cost structure refers to the relative proportion of ficed and varible costs in an organizaion.
Managers often have some latitude in trading off between these two types of costs. Without
knowing the future, it is not obvious which cost structure is better. Both have advantages and
disadvantages.

Operating Leverage

Operating leverage is a measure of how sensitive net operating income is to a given

percentage change in dollar sales. Operating leverage acts as a multiplier. If operating
leverage is high, a small percentage increase in sales can produce a much larger
percentage increase in net operating income. The degree of operating leverage at a given
level of sales is computed by the following formula:

Contribution margin
Degree of operating leverage =
Net operating income

The degree of operating leverage can be used to quickly estimate what impact various
percentage change in sales will have on profits, without the necessity of preparing detailed
income statements.

Structuring Sales Commissions

Companies usually compensate sales people by paying them a commission based on sales,
a salary, or a combination of the two. Commissions based on sales dollars can lead to lower.

Sales Mix

The term sales mix refers to the relative proportions in which a company’s products are sold.
The idea is to achieve the combination, or mix, that will yield the greatest amount of profits.
Most companines have many products, and often these products are not equally profitable.
Hence, profits will depend to some extent on the company’s sales mix. Profits will be greater
if high-margin rather than low-margin items make up a relatively large proportion of total
sales.

Sales Mix and Break-Even Analysis

If a company sells more than one product, break-even analysis is more complex than
dicussed to this point. The reason is that different product will have different selling prices,
different costs, and different contribution margin. Consequently, the break-even point
depends on the mix in which the various product are sold. In preparing a break-even
analysis, an assumption must be made concerning the sales mix. Usually the assumption is
that it will not change. However, if the sales mix is expected to change, then this must be
explicitly considered in any CVP computations.

Assumptions of CVP Analysis

A number of assumptions commonly underlie CVP analysis:

1. Selling price is constant. The price of a product or service will not change as volume
changes.

2. Costs are linear and can be accurately divided into variable and fixed elements. The
varible element is constant per unit, and the fixed element is constant in total over the entire
relevant range.

3. In multiproduct companies, the sales mix is constant

4. In manufacturing companies, inventories do not change. The number of units produced

equals the number of units sold.